An affordable stock with years of potential

In this case, the technology is the internal combustion engine (ICE). 

Companies heavily exposed to the fallout from the rise of the electric vehicle (EV) have for years looked at how to prepare for the transition away from traditional vehicles. But continued demand for diesel and petrol cars – which comes alongside, rather than instead of the broader shift to EVs – means suppliers into that market can still offer compelling opportunities for investors. 

Johnson Matthey (JMAT), which sells catalytic converters, exhaust systems and related technologies, has already admitted defeat on its foray into the EV space, after it sold off its battery materials unit last year having acknowledged that it would not be able to compete with existing players in the market.

“The acceleration of the capacity required in the market is happening at a time when we are trying to scale up as rapidly as possible,” said then-chief executive Robert MacLeod in November 2021. “We’re doing this with a technology and scale of manufacturing [that] are not our core expertise.”  

Where does that leave the company? Not terribly positioned, even in its traditional markets. The outlook for internal combustion engine cars does not look so poor when hybrids (a business line well-served by Johnson Matthey) are included, and the company is now slimmer and more profitable than when it was trying to make waves in the EV space. A revived commercial approach should also help drive sales in existing areas of expertise, and it still has potential growth markets to tap into. 

Short-term outlook

Johnson Matthey's clean air division, focused on catalytic converters and related technologies, still accounted for 65 per cent of the company’s sales in 2021-22. Of this segment, a third of revenues stem from heavy-duty diesel vehicles, with the remainder focused on cars and other light-duty vehicles.

In recent months, the company’s orders have strengthened as the car industry has rebounded after the supply chain difficulties of 2021 and early 2022. There are now concerns about demand dropping as consumer spending falls, but there is helpful support from another industry dynamic – the ICE cars being sold in the US and Europe must now meet tougher emissions restrictions, and this creates more demand per vehicle for Johnson Matthey products. 

Meanwhile, Chinese buyers are likely to more than make up for the decline in sales in Europe. Forecasts by UBS predict European plug-in electric vehicle (PHEV), or hybrid, sales peaked last year, at just over 1mn. By 2030, that figure is estimated to fall to just under 230,000 as fully electric vehicles take over. But the investment bank sees Chinese sales rising from 1.4mn to 3.2mn over the same period. They are also set to grow in the US, more than doubling to 500,000.

Technology could shift further and create more problems for hybrids. But recent suggestions that the EU might relax its petrol and diesel-powered car sales ban, scheduled for 2035, indicate the middle-ground technology could persist well into the next decade.

EV sales have remained strong in the past few years, with total market share rising from less than 5 per cent in 2020 to 14 per cent in 2022. The International Energy Agency forecasts 18 per cent market share this year in a growing car market. But this figure also includes hybrids, and while pure EVs will make up the lion’s share of growth, the mixed models will see sales growth as well as a result of the regional mix.

The heavy-duty market has also shown there is life in it yet. Panmure Gordon analysts forecast last year that heavy-duty diesel sales in Johnson Matthey’s clean air division would rebound swiftly from the 2021 low of £741mn to £1.1bn in the current financial year, and that the light-duty vehicles unit would also see improvement, albeit not as strong. Analysts Lacie Midgley and Sanjay Jha pointed to cost pressures given the five-year sales deals Johnson Matthey usually signs with carmakers (and the significant increase in inputs such as energy seen since many deals were signed), but said the company was “seeing some early successes” in recouping those expenses. 

Rough ride

Still, Johnson Matthey has faced a tougher launching pad than expected for its new keep-it-simple operating model. “Since outlining our strategy, the macroeconomic environment has deteriorated,” chief executive Liam Condon acknowledged in November 2022. This strategy is simple: sticking to what the company is good at and making more money there. 

The compnay is targetting a 15 per cent reduction in senior management roles and a £35mn annual cut in spending for the financial year that ended on 31 March. But Jefferies analyst Charles Bentley suggested in April that investors would still see only “modest operational and strategic progress” when full-year results are released later this month. Bentley also cut his earnings forecast because of the fall in platinum group metal prices. 

But he was positive on the business itself, largely because of the prospects for other divisions. “JMAT is making progress in demonstrating it can remain a growth business,” he said, noting: “Converting its customer pipeline, across catalyst and hydrogen technologies, to order wins and ultimately revenue generation remains fundamental to the investment case.” 

Condon said the first half had seen “very strong double-digit growth” for the catalyst technologies unit, which sells into the chemicals and energy sectors and accounted for 12 per cent of revenue in FY2022, while sales doubled for the nascent hydrogen unit. As the name implies, that sector – which accounted for 1 per cent of sales last year but is currently chasing government cash in the US and Europe – produces clean hydrogen technologies.

There is a risk that this unit goes the same way as the batteries operation, but the fact that clean hydrogen is at a much earlier stage of development does at least even the playing field. Asked if Johnson Matthey had enough of a foothold in the industry already to benefit, Adrian Ng, an analyst at CFRA Research, said a “rising tide lifts all boats”. 

It will remain a relatively small part of the business for now; a FY2025 sales target of over £200mn would still amount to just 5 per cent of forecast revenue. But given the company's existing expertise, there is less risk technology-wise here than in the failed battery venture. That should avoid the kind of costly reversal sustained in the 2022 financial year, when the company booked just over £600mn in impairments from offloading the battery unit as well as its health business.

Plug it in

The use of capital in a company uncertain about its future is always going to be critical, and recent developments suggest there is already a preference for not spending big on new capabilities – shown through a joint venture (JV) with US company Plug Power (US:PLUG), announced earlier this year, to build a hydrogen fuel cell factory. 

The technology here is catalyst-coated membranes (CCM), which are used in hydrogen-producing electrolysers. While the Plug Power JV factory plan could ultimately build what is billed as the “largest CCM manufacturing facility in the world”, analysts don’t foresee any massive splurges in the coming years – capital spending is forecast to remain between £300mn and £420mn between 2023 and 2026, with return on equity (ROE) hovering around the 13 per cent mark.

This is below the heady days of a decade ago, when ROE was comfortably over 20 per cent, but the company is operating in a different environment now. 

It’s also worth pointing out the key dynamic of the hydrogen sector as it stands: inhaling government cash is the key objective. Executives across the board have been open about US and EU subsidies and grants driving their interest in the area, such as the US Inflation Reduction Act (IRA). 

As Ng said, this will remain a small part of Johnson Matthey’s business in the next few years. But it does offer some growth as its exhaust business gradually slows. So does the catalyst tech business, the opportunity pipeline for which rose from 70 to 100 in the six months to September, alongside new wins and the prospect of further IRA-driven business.

For now, given the valuation of 10 times forward price/earnings (below the five-year average of 12 times), a relatively positive outlook for the ICE auto industry, and the company's new focus on minimising costs and driving sales growth, Johnson Matthey is worth sticking in the garage.